Computer Associates Tests Patience

Computer Associates' ( CA) strange accounting practices have made it a lightning rod for rating agencies' attention and might have been one of the reasons Moody's Investors Service warned of a downgrade on the firm's debt, according to some analysts.

Shares of Computer Associates fell 13.7% to $27.08 Wednesday after Moody's said it was reviewing the firm's debt for possible downgrade, citing weakened cash flow, competitive pressures and the macroeconomic environment.

The world's fourth-largest software maker responded by saying that its cash-flow position is strong and competitive successes should support the current debt rating. However, the announcement forced the company to delay closing a $1 billion debt sale, the proceeds of which it had intended to use to pay down existing debt.

"I don't think Moody's has uncovered anything new, but in the wake of Enron and Tyco, Computer Associates stands out because it's pushing the envelope on accounting," noted Peter Goldmacher, an analyst at Merrill Lynch. (His company has not done any underwriting for CA.)

Ratatouille

Analysts said CA's decision to publish "pro forma pro rata" numbers, which are more aggressive than ordinary pro forma numbers, has made the company more susceptible to scrutiny.

In November 2000, Computer Associates announced that it would recognize revenue from customers over the life of a software contract, rather than recognizing most of it upfront. The new model was also expected to give customers more flexibility to change their orders.

However, because of that accounting change, the company began publishing pro forma pro rata numbers, which means the firm has recrunched historical numbers to show them as if the company had been recognizing revenue in its new way all along.

Analysts note that under the new accounting method, actual earnings and revenues are overstated, as this reporting method was designed to mitigate the impact of the change from a licensing model to a subscription-based model.

However, others argue that generally accepted accounting principle numbers may also understate the potential power of CA's new business plan and its ability to work more closely with customers to secure smoother, more predictable revenue streams.

To be fair, Computer Associates has always said the pro forma pro rata numbers are merely a way to help investors understand an evolving business model that sacrifices near-term sales for long-term strategic goals. Also, the company does report GAAP-compliant numbers and, in fact, on Wednesday reaffirmed its guidance of $770 million in revenue and an operating loss per share of 4 cents to 5 cents a share for the fourth quarter.

Using the new accounting method, CA expects pro forma operating earnings of 72 cents a share, on revenue of $1.470 billion. Thomson Financial/First Call estimates a profit of 69 cents.

Operational Strengths

Computer Associates said there has been no material change to its business or financial results, including cash-flow generation, since it issued its third-quarter earnings release on Jan. 22, that would have prompted Moody's action.

Speaking at the Goldman Sachs conference in La Quinta, Calif., CEO Sanjay Kumar said he "cannot fathom" what concerns someone would have with its repayment of debt and stressed that Moody's announced it will review Computer Associates for a possible downgrade ? rather than downgrading the stock. He said Computer Associates has pushed back settlement of terms of a $1 billion debt offering by a day or so in light of the Moody's announcement.

Kumar also noted the new debt issue is meant to take advantage of current interest rates and represents a reshuffling of the company's debt rather than adding to it. He noted that the company has been aggressively paying down debt, including a $250 million payment in January. Computer Associates has paid down $850 million in the 10 months of its current fiscal year and paid down $900 million in debt in fiscal year 2001.

Still, analysts say the firm's new accounting method may have raised some red flags in light of recent events.

Moody's said while it had anticipated CA's infrastructure management business to suffer operationally in line with the current economic downturn, the decline appears to be larger than expected. It also expected the breadth of the firm's portfolio, especially in faster-growing storage and security software, to provide greater overall support than it has.

The rating agency also has concerns about the ability of the business, including infrastructure management software for the mainframe, to generate appropriate returns over time relative to its substantial asset base and the debt supporting these assets.

The review will focus on the operational strength of CA's diversified software portfolio, particularly in enterprise management, storage, and security software, and on expected changes to its capital structure.

Despite the hit to Computer Associates' share price Wednesday, some say the concerns are overblown.

Prudential Securities analyst John McPeake believes the firm's cash flow is still strong and said it has been paying down debt. McPeake noted that Standard & Poor's reiterated its short- and long-term debt ratings just last week, and he advised investors to buy on weakness. (Prudential Securities has not done any underwriting for Computer Associates.)